The improbable success of The
Big Short, a scathing and hilarious tutorial on making money during
a financial crisis, probably has a lot of people thinking that now might
be a good time to start betting against the current bubble(s).
That's a well-timed thought because it comes after three long years in which
shorting was really, really hard. Why was it hard? Because easy money -- at
first -- floats all boats. When interest rates are low and financing is readily
available, even the crappiest companies can pay their bond interest and support
their share price with debt-fueled share repurchases. The uniformity of the
past few years' bull market was so extreme that buying the most heavily-shorted
stocks -- on the assumption that those companies would have access to sufficient
capital to support their market value, thus forcing the shorts to cover at
ever-higher prices -- was a successful and widely-practiced strategy.
But as Warren Buffett likes to say, when the tide goes out you see who's swimming
naked. And in the past year, as the US stopped quantitatively easing, China
stopped buying commodities and oil tanked, the tide has gone out with a vengeance.
Already, the Russell 2000 index of small-cap stocks is down 22 percent from
its cycle high and fully
half of the S&P 500 is down more than 20%.
Long-suffering short sellers, as a result, now find themselves in a target-rich
environment reminiscent of The Big Short's final act. Dallas-based Bearing
Fund is a case in point. After a "humbling" couple of years, partners Bill
Laggner and Kevin Duffy have ridden some high-profile short positions (including SunEdision, Wynn
Resorts and Valeant) to
big gains, with -- if this bubble deflates according to the standard script
-- much more still to come. Here's a short Q&A compiled from an exchange
of emails:
DollarCollapse: The past few years have been tough for short sellers.
But during 2015 that changed in a big way. What happened?
Laggner and Duffy: The commodity bubble actually began to crack in
2011, led by deterioration in China and the first convincing signs of governments
losing control. But speculators continued to stay at the casino, especially
in the US where short-term interest rates remained at zero. So unlike the last
bubble where real estate was the main collateral, this series of echo bubbles
included any kind of financial asset.
After the commodity sector was hit, other related countries' stocks and currencies
began to falter, led by Brazil and Russia. The last shoes to drop were various
sectors of the US economy as endless intervention finally exhausted itself
and nonfinancial operating profits peaked. By the end of 2015, 52% of the stock
market was down 15% or more.
DC: You maintain a list that's a mirror image of those that most money
managers compile, because yours -- the Bearing Short Index -- is made up of
things that you expect to go down. How has it performed historically and recently?
L & D: When we created the Bearing
Credit Bubble Index in 2004 our goal was to demonstrate where the real
distortions were playing out from central bank largess. Those sectors eventually
declined by 70%-80%.
About 18 months ago we constructed an equal-weighted index of our short selling
universe at the time, 53 stocks. From its all-time high on June 23, the Bearing
Short Index was down 20.3% by mid-December. Over the same period, the S&P
500 was -4.8%. Of the 53 stocks in the index, 11 were down over 40% from their
52-week highs while 5 were down over 60%.
In other words, the past six months have been ideal for short sellers and
miserable for a number of high profile hedge funds which have been long many
of these formerly highflying stocks.
The coordinated central banking interventions this cycle led to numerous distortions
in a variety of sectors and over the last 12 months the Bearing Short Index
has declined at roughly 4X the rate of S&P 500. So clearly we've identified
some of the more egregious actors.
DC: What are your main themes? In other words, what parts of the global
economy do you expect to do most badly from here?
L & D: Prolonged ZIRP has fueled the biggest bubble since '00.
China led the charge by expanding debt by over $18 trillion since '09, so unwinding
that means lower commodity prices and Chinese bank solvency problems.
Meanwhile, the infatuation with anything offering yield like REITs, MLPs,
junk bonds, alternative energy "yieldcos" will end in tears once the commodity
carnage is recognized by the market.
Finally, much of the debt from the prior two bubbles was never allowed to
deflate. So excess everything (derived from cheap credit) will ultimately lead
to contraction in economic activity/profits, driving most asset prices back
below fair market value.
DC: Right now the world is in chaos and most categories of financial
assets are falling hard. How long do you see this continuing and how will you
know when a bottom is in?
L & D: Well, we know that getting here [since the 2008-2009 crisis]
took almost $63 trillion in new debt globally and a tremendous level of financial
engineering/leverage, so with pieces of the commodity cycle crashing to earth
we would say this is the top of the second inning. Bottoms take time and unfortunately
moral hazard created by bailouts/stimulus has encouraged many to await the
next rescue mission experiment. Of course, margin clerks are getting busy and
many of the speculators are playing with rented merchandise, so selling begets
selling.
At the bottom you will see despair, frustration, and obviously no discussions
at cocktail parties about stocks or real estate investing.
DC: What role do precious metals play in the world you see coming?
How do you choose among the various ways of owning/betting on gold and silver?
L & D: Gold is unencumbered money so owning gold is really just
insurance in the event fiat currency systems end badly. Of course owning gold
miners is much more challenging as the industry became distorted from suppressed
interest rates and related malinvestment. We've tried to find good operators
in relatively safe jurisdictions with lows costs. The recession in mining coupled
with low energy costs has allowed many of these companies to lower all-in sustaining
costs so gold miners look attractive again.
DC: You're both followers of the Austrian School of economics. How
does this inform your decision making?
L & D: The economy is a complex adaptive system similar to the
brain, the Internet, and ant colonies. The connections are important and information
gets transmitted via the price system. Austrians recognize that interfering
with freely determined market prices (by central command) sends the wrong signals
to economic actors. When a central bank suppresses the price of credit - interest
rates - bad things happen. To quote Jim Grant, "This is like turning all the
traffic lights green." One possible result of this is inflated asset prices
and an unsustainable boom.
Austrian Business Cycle Theory tells us that the depth of the bust will be
proportional to the boom. Since we just witnessed a tripling of stock prices
over a 6 year period, we expect the ensuing bust to be historic. As Austrians,
we also know to look for areas of malinvestment on the short side, typically
long-term grandiose projects (like record high skyscrapers in China) or consumer
goods where long-term financing is offered (such as 7 year auto loans). On
the long side, it suggests we keep it simple and invest in basic necessities
like food and affordable luxuries like beer. "When the going gets tough, people
eat, drink and smoke."